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Tuesday, March 31, 2015

Does the U.S. economy face secular stagnation? I am skeptical, and the sources of my skepticism go beyond the fact that the U.S. economy looks to be well on the way to full employment today. First... at real interest rates persistently as low as minus 2 percent it’s hard to imagine that there would be a permanent dearth of profitable investment projects. As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period.

His successor, Janet Yellen, is also skeptical. She acknowledged in a speech the possibility of secular stagnation, but believes it is an unlikely outcome. Her baseline scenario is for the U.S. economy to continue to recover and, as a consequence, to continue to pull up the real equilibrium interest rate:

[T] economy's underlying strength has been gradually improving, and the equilibrium real federal funds rate has been gradually rising. Although the recent appreciation of the dollar is likely to weigh on U.S. exports over time, I nonetheless anticipate further diminution of the headwinds just noted over the next couple of years, and as the equilibrium real funds rate continues to rise, it will accordingly be appropriate to raise the actual level of the real federal funds rate in tandem, all else being equal.

If we take the New York Fed's estimate of the 10-year treasury term premium and risk-neutral nominal rate as given, then the market is already pricing in a non-secular stagnation future as seen in the 10-year real risk-free treasury yield below:

The red line is a risk-adjusted measure of the expected average real short-term
interest rate over the next ten years. Put differently, this measure
reveals the expected path of real short-term interest rates and it is pointing up. Since it is risk free, it should only be reflecting the
expected fundamentals of the real economy over the next 10 years (see here for further explanation). It started rising in early 2014 and now has been positive for about five months. That bodes well for the economy.

Now the real risk-free 10 year yield seems to have stalled a bit in the past three months, but overall it appears to be on it way to its pre-crisis trend that was discussed in my previous post. Dare I say history is repeating itself when it comes to secular stagnation?

Monday, March 30, 2015

Blogging isn't dead.
At least, Ben Bernanke, former chairman of the Federal Reserve, doesn't
think so: He's now blogging at the Brookings Institution. In his first post, he says he wants to write about this fascinating chart, which shows the steady decline in interest rates over the past 30 years or so.

The question of why interest rates keep falling is an important one these days. Former Treasury Secretary Larry Summers has argued
that declining real rates are a symptom of secular stagnation, meaning
the global economy just isn't what it used to be, for some reason, and
might never recover its old strength. Here's what Summers told Wonkblog about his theory, and here's a response from Western Kentucky University's David Beckworth, who disagrees with him.

It would be great to see Bernanke engage this secular stagnation debate. Although Larry Summers never directly responded to me, he did reply to Marc Andreessen's tweetstorm where my critique was raised. The crux of my argument was that the long-decline in real interest rates given as evidence of secular stagnation ignores the sustained decline in risk premiums. Once this phenomenon is recognized, there is no long decline in real interest rates.

Larry Summers replied to my critique with the following:

Markets – in the form of 30-year indexed bonds – are now predicting that real rates well below 2 percent will prevail for more than a generation... I think it is quite plausible and consistent with Marc’s picture that equilibrium real rates were roughly constant at around 2 percent until the mid-1990s and have trended downward since that time.

Looking to inflation indexed bonds or TIPs as a guide to the market's prediction of real rates is also misleading. It too fails to account for a liquidity premium priced into TIPs. On his second point, below is an updated version of the picture to which Larry Summers says he sees a downward trend since mid-1990s. Note that the real interest rate is now turning sharply up whereas before it was still flat. The real interest appears poised to return to its previous trend.

That the real interest rate appears to be returning to its previous trend--rather than finding a new lower one as suggested by Summers--makes sense if we plot this interest rate against the CBO's output gap. This is done in the figure below and reveals a striking fit. It also suggests the real culprit behind the sustained low rates is a prolonged business cycle. Now that the economy finally appears to be on a path to full recovery, the output gap is closing and the real interest rate is following it. So much for the smoking gun of secular stagnation.

I really hope Ben Bernanke joins this conversation. He had a great speech back in March 2013 that hinted at some of these topics. Welcome to the blogosphere Ben!

Saturday, March 28, 2015

The rise of the US sunbelt can be understood largely as a response to the emergence of widespread air conditioning, which made places that are warm in the winter attractive despite humid, muggy summers. It’s a gradual, long-drawn-out response, because location decisions have a lot of inertia[.]

And this:

[T]here’s a real demographic turning point for the South circa 1960, as a steadily falling share of the total US population shifts to a sustained rise...this turning point coincides with the coming of widespread home air conditioning. So when you ask why Sunbelt states have in general grown faster than those in the Northeasy, don’t credit Art Laffer; credit Willis Carrier.

This is an intuitive explanation, but it is incomplete and cannot explain recent net migration patterns within the United States. On the first point it is important to note that the South's economy actually began to accelerate in the 1930s and 1940s.

This takeoff is one of the great stories from 20th century U.S. economic history. From the close of the
Civil War up through World War II, the South's economy had been
relatively undeveloped and isolated from the rest of the country. This
eighty-year period of economic backwardness in the South stood in stark
contrast to the economic gains elsewhere in the country that made the
United States the leading industrial power of the world by the early
20th century. Something radically changed, though, in the 1930s and
1940s that broke the South free from its poverty trap. From this period
on, the South began modernizing and by 1980 it had converged with the
rest of the U.S. economy. But why the sudden break in the 1930-1940
period?

There have been a number of attempts to explain this sudden change in the trajectory of the South. Gavin Wright (1997) attributes it to the opening up of labor markets, Connolly (2004) looks to improved human capital formation, Cobb (1982) points to industrial policy, Beasley et al. (2005) finger increased political competition, Bleakley (2007) sees hookworm eradication as important, Glaeser and Tobio (2008) look to housing regulations, and Bateman et al (2009) see the large public capital investments in the South during the 1930s and 1940s as facilitating a 'Big Push' for the region. The takeaway is that there were probably many factors that supported the rise of the South, not just air conditioning.

The other problem with looking to air conditioning as the reason for the rise of the South is that there are recent net migration patterns that show movement into the warm South from other warm regions. not just from cooler regions. For example, this Census Bureau figure shows for the 1995-2000 period net migration out of California often went into other warm states, including many in the South.

To further illustrate this point, he next three figures focus in on three big counties in Texas: Harris Country (Houston), Dallas County (Dallas), and Travis Country (Austin). They all show for the years 2008-2012 net inflows coming from southern California where it is also warm (source):

So air conditioning cannot be an important story over this time. It may have contributed, along with the other factors listed above, to the the initial takeoff of the American South, but not so in recent decades. The rise of the South is a far more complicated story.

Friday, March 27, 2015

Just a quick note on whether the Fed should raise interest rates later this year. One concern that many observers have with the Fed tightening is that nominal wage growth has yet to show any signs of accelerating. They often point to the employment cost index which only shows modest nominal income growth.

An alternative way to think about this issue is to look at the University of Michigan/Thompson Reuters Survey of Consumers where households are asked how much their dollar (i.e.
nominal) family incomes are expected to change over the next 12 months. I have used this series in the past to talk about the stance of monetary policy. This measure had averaged near 5 percent prior to the crisis, but then crashed and flat lined near 1.5 percent thereafter. The Fed, I argued, should have restored expected household dollar income to its 5 percent trend growth and its failure to do so was a dereliction of duty.

How times have changed. Here is the same series updated to the present. Since late 2013 it has accelerated and is now almost back to 5 percent.

This suggests the economy is heating up and getting closer to full employment. If we plot this series against the employment cost index we get the following figure. Note the expected nominal income growth tends to lead the actual income growth. This suggest that wages are primed to start accelerating.

So the wage growth concerns over the Fed tightening this year may soon become a moot point. This may one reason some folks like James Bullard are calling for a rate hike later in the year.

Thursday, March 19, 2015

Ramesh Ponnuru has an article in the National Review where he revisits the 'test' of Market Monetarism put forth by Paul Krugman and Mike Konczal in 2013. Here is Ramesh:

The story begins in late 2012. The Federal Reserve had begun its third round of monetary expansion following the economic crisis of 2008. Keynesian economists were sounding an alarm about the deficit-cutting measures — a combination of tax increases and spending cuts — that were scheduled to take effect at the start of 2013. Rapid deficit reduction, they warned, would harm the economy. A letter from 350 economists referred to “automatic ‘sequestration’ spending cuts everyone agrees should be stopped to prevent a double-dip recession.”

It is worth noting that these concerns about a double-dip recession
were translated into explicit forecasts about the number of jobs that
would be lost. Estimates ranged from 660,000 to 1,800,000 jobs would be
lost as can be seen be below:

David Beckworth, a professor of economics now at Western Kentucky University, and I challenged this view. In an op-ed for The Atlantic’s website, we wrote that the Federal Reserve could offset any negative effect that deficit reduction might have on the economy.

[...]

In April, the liberal economics writer Mike Konczal resurrected an op-ed that Beckworth and I had written for The New Republic in 2011 making the same basic argument about the power of monetary policy, which is associated with a school of thought sometimes called “market monetarism.” He wrote: “We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed... Krugman concurred with Konczal, writing that “we are in effect getting a test of the market monetarist view right now” and “the results aren’t looking good for the monetarists.”

Read the rest to learn how the 'test' turned out. Here is my own take on how the test turned out.

Sunday, March 8, 2015

Update: Here is the second half of my interview which aired on Tuesday.

On Friday I was interviewed by Erin Ade on Boom Bust. We discussed why the Eurozone is not an optimal currency area--low labor mobility, limited fiscal transfers, differing regional business cycles--and why this means a one-size-fits all monetary policy is bound to make problems for this monetary union.

This discussion was a follow-up to a recent post where I illustrated the challenges of a one-size-fits-all monetary policy by plotting Taylor rules for the Eurozone's core and periphery economies. These Taylor rules prescribe very different interest rates for these two regions since the Euro's inception, yet there is only one interest rate target. What to do? The chart below, which was used on Boom Bust, reveals what the ECB did in practice:

Note that the ECB policy rate (grey) and the core Taylor rule rate (green) track each other relatively closely. This means the ECB adjusted its interest
rate target in a manner more consistent with the core economies. It also means the ECB policy was destabilizing for the periphery. For example, it was far too easy for the
periphery prior to 2008--helping fuel the run up in debt, soaring asset prices, and current account deficits in those economies--while after that time it has been far too tight. For the core, ECB policy has been about right since 2010. This explains, in part, the ECB's reluctance to ease since then.

Interestingly, this is not the first time European monetary policy has served to stabilize the core economies while destabilizing the periphery. The first go-round occurred in 1992 under the European Monetary System (EMS). Under this arrangement, each country had their own currency but was pegged to the German Deutsche Mark. This meant European monetary policy was effectively set by the Bundesbank in Germany. Unsurprisingly, what was good monetary policy for Germany--the core economy--was not necessarily good for the periphery.

This became apparent in 1992 when Germany, worried about overheating from the spending on its reunification, decided to tighten monetary policy. To maintain their pegs, the EMS countries had to follow suit and tighten too. For many countries, though, this was hard to do because their economies were already weakening. Monetary policy, in other words, was tightening in order to stabilize the core economy even though the periphery needed easing. In the United Kingdom and Italy the pain of this tightening proved to much and they were forced to leave the EMS. Other periphery countries like Spain and Portugal limped along.

So the problems in the Eurozone periphery since 2010 are an eerie Deja Vu of the 1992 EMS experience. In hindsight, then, it seems that the periphery should have known better than to try a second monetary marriage with the core economies. As the saying goes, fool me once shame on you; fool me twice shame on me. The core economies continue to have the upper hand when it comes to the conduct of monetary policy in the Europe. And it does not seem that this will change anytime soon. This is a lesson the periphery needs to learn.

Update: What this all means is that even if the current Greek crisis gets resolved, there will be more crises in the future for the Eurozone. It is unlikely that peripheral conturies will undergo the structural change needed to make them succeed in a Eurozone whose monetary policy favors the core. So at some point it seems likely that the history of the UK and Italy leaving the EMS in 1992 will be repeated in the Eurozone.

Thursday, March 5, 2015

After six years of low interest rates many yields are now crossing the zero percent boundary. Interest rates in Europe and Australia have turned negative on some government and corporate bonds. The decline of these interest rates into negative territory has caused much consternation among two groups of observers.

The first group astonished by this development are those who believed interest rates were pegged by the 'zero lower bound' (ZLB). Interest rates were not supposed to go below zero percent because one could always hold physical cash and earn zero percent rather than holding bank accounts that earned a negative interest rate. Consequently, a breaching of the ZLB has been mind-blowing for some folks. Here, for example, is Matt Yglesias:

Something really weird is happening in Europe. Interest rates on a range of debt... have gone negative.In my experience, ordinary people are not especially excited about this. But among finance and economic types, I promise you that it's a huge deal — the economics equivalent of stumbling into a huge scientific discovery entirely by accident.

Paul Krugman similarly observes that crossing the ZLB is something he never expected. While many are surprised, the key idea behind the ZLB still holds. At some point it will become worthwhile to hold cash rather than bank deposits earning a negative return. It is just not at zero percent because of storage costs as recently noted by Evan Soltas and David Keohane. So if interest rates continue to fall they will eventually hit the effective lower bound and currency demand will soar.

It is worth pointing out that JP Koning has been making this point about storage costs and the ZLB for a long time. For example, he had a post back in 2014 discussing the implications of the ECB's large €500 note for ZLB:

The ECB has differentiated itself from almost all other developed country central banks by issuing a mega-large note denomination, the €500 note... The €500 note creates a uniquely European problem because its large real value reduces the cost of storing cash and therefore raises the eurozone's lower bound. Think about it this way. To get $1 million in cash you need ten thousand $100 bills. With the €500 note, you need only 1,545 banknotes, or about one-eighth the volume of dollar notes required to get to $1 million. This means that owners of euros require less vault space for the same real quantity of funds, allowing them to reduce storage costs as well as shipping & handling expenses. In other words, the €500 note is far more convenient than the $100 note, the €100, the £100, the ¥10,000, or any other note out there (we'll ignore the Swiss). Thus if Draghi were to reduce rates to -0.25%, or even -0.35%, the existence of the not-so-inconvenient €500 very quickly begins to provide a very worthy alternative to negative yielding ECB deposits. The lower bound isn't so low anymore.

All the more reason to remove the €500 note in order to provide the ECB with further downward flexibility in interest rates. If the existence of the €500 note means that Draghi can't push rates below, say, -0.35% without mass cash conversion occurring... but the removal of said note from circulation allows him to drop that rate to -0.65% before the cash tipping point, then he's bought himself an extra three rate reductions by removing the €500.

So in addition to its problematic monetary policy, the ECB also has a €500 note that makes it harder for interest rates to reach their market-clearing levels. (Yes, this is a currency union that seems designed for failure.) Institutional details matter and JP Konign is one of the best on this when it comes to monetary policy.

So the ZLB is still binding in spirit if not exactly at zero percent. Fortunately, there are ways to get around it without eliminating currency.

The second group that finds the move into negative interest rates unsettling do so for a different reason. They see it as another step by central banks to artificially push down interest rates. This is problematic for some, like Bill Gross, because it means financial markets are being distorted. For others, like Robert Higgs, the low-interest rate policy is troubling because it is causing the immiseration of people living on interest income.

In both cases the premise is that central banks are causing interest rates to remain low. But this premise assumes too much. It could be the case that central banks over the past six years were adjusting their interest rate targets to match where the market-clearing or 'natural' interest rate was going. That is, as the economy weakened interest rates naturally would have fallen and, given the severity of the crisis, may have gone well below zero. Central banks were simply attempting to follow the market-clearing interest rate down, but decided to stop at zero percent because they believed they could not go any further. Even though we now know monetary authorities had some wiggle room left beneath zero percent, they still would have been constrained by the effective lower bound had they kept pushing.

The irony of this is that the Bill Gross and Robert Higgs of the world, who usually are free-market advocates, should be in favor of allowing interest rates to fall when necessary. They believe in the power of prices to clear markets, so they should be open to the possibility that sometimes--in severe crises
like the Great Depression or Great Recessions--interest rates may need
to go negative in order to clear output markets. If so, it is incorrect for them
to ascribe the low interest rates to Fed policy since it was
simply chasing after a falling natural interest rate.

This understanding also means that the effective lower bound on interest rates is a price floor that distorts markets. And any good capitalist worth his salt should be in favor of abolishing this price floor and allowing prices to work. On this point, Paul Krugman is a better capitalist than Bill Gross or Robert Higgs since Krugman believes interest rates are low because of the economy, not the Fed.

That the market-clearing interest rate turned negative over the past six has been borne out in multiple studies. One prominent study that shows this is a 2012 Peter Ireland paper in the Journal of Money, Credit, and Banking. Another example comes from Michael Darda of MKM Partners. He estimates the market clearing interest rate by looking at the historical relationship between the federal funds rate and slack in the prime-age working force plus a risk premium. His estimated market clearing interest rate--the estimated Wicksellian equilibrium nominal short rate--also shows a negative value over this period.

So be careful when thinking about interest rates. They may be negative for good reasons.

Monday, March 2, 2015

In my own case, I’d guess that about 80 percent of what I’ve had to say about macroeconomics since the crisis was prefigured in my 1998 liquidity trap paper, which was classic MIT style — a stylized little model backed by and applied to real-world events, with lots of data used simply. (Seriously, skim that piece and you’ll see why I sometimes seem so frustrated: People keep rolling out arguments I showed were wrong all those years ago, or trotting out arguments I made back then as something new and somehow a challenge to conventional wisdom.)

Here is a carton figure from an earlier post where I manage to depict Krugman's frustration. Look closely at his t-shirt, it says it all. To be clear, I
agree with the key point of Krugman's 1998 paper: for monetary policy
to have a meaningful effect on a depressed economy it has to commit to permanent monetary injections. And that is something the Fed failed to do over the past six years.

I made the case in my last post that the Eurozone crisis was largely a monetary policy crisis. That is, had the ECB lowered interest rates sooner and begun its QE program six years ago the fate of the Eurozone would be more certain. Instead it raised interest rates in 2008 and 2011, waited until this year to begin QE, and allowed inflation expectations to drift down. In short, had the ECB been more Fed-like the Eurozone crisis would have been far milder.

This begs the question as to why the ECB failed to act more Fed-like. Why did it effectively keep monetary policy so tight for so long?

To answer these questions it important to note that there were actually two stages to the Eurozone crisis. The first stage began in 2008 when the ECB raised interest rates just as the Eurozone economy began to weaken. This explicit tightening along with the subsequent failure of the ECB to offset the passive tightening of monetary policy through 2009 adversely affected all of the Eurozone. In this stage nominal spending--or aggregate demand--fell in both the core and periphery economies. Consequently, real economic activity also collapsed in both regions. This can be seen in the two figures below. The first figure shows nominal spending for the two regions while the second one reports real GDP growth and the change in the unemployment rate.1

The above two figures also point to the second stage of the Eurozone crisis which begins in 2010. The first figure shows that while aggregate demand continues to grow in the core regions (albeit below trend) after 2010, it actually falls in the periphery. Likewise, the second figure shows that for the 2010-2013 period real GDP growth rises and the unemployment rate falls for the core, while the opposite happens to the periphery. The core heals while the periphery bleeds during this stage.

What these figures suggest is that the first stage of the crisis was a Eurozone-wide monetary crisis, while the second stage was only a regional Eurozone monetary crisis. In other words, the first stage of the crisis was not that different than what happened in the United States during 2008-2009. And for the core economies as a whole the ECB was sort of Fed-like for them after 2010. It was, then, the periphery economies that suffered from the absence of Fed-like policy after 2010.

This notion is borne out by looking at Taylor rules fitted to these two regional economies. Following the work of Fernando Nechio, I created Taylor rules for these two regions and plotted them alongside the actual ECB policy interest rates:2

This figure shows that monetary policy was too tight in 2008-2009 for both regions, but afterwards it was too-tight only for the periphery. Hence, the second stage of crisis was a regional monetary policy crisis localized to the periphery.

The fact that second stage of the crisis was a regional one speaks to what I see is the real underlying reason for the monetary policy crisis: the Eurozone is an unequally yoked currency union. It has member states that have economies so vastly different that applying an one-size-fits-all monetary policy is bound to create problems.

The Taylor rules in the figure above vividly illustrate s this problem. It shows a persistent pattern of the ECB setting its interest rate target in a manner more consistent with the core economies. For example, when the Eurozone first formed in 1999 the core economies--particularly Germany--were struggling so the ECB lowered interest rates to accommodate them. Doing this, however, meant monetary policy was way too loose for the periphery as seen by the large gap between the red and dashed lines above. Monetary policy would continue to stay too loose for the periphery up through 2008. After the crisis, ECB policy has again been more consistent with the core economies, but this time it has meant monetary policy has been too tight for the periphery.

Think about what this means for the periphery. Countries like Greece, Ireland, and Spain were on average growing in nominal terms anywhere from about 8 to 15 percent between 1999 and 2004. The ECB policy rate during this time averaged near 2 percent. This large spread between the nominal growth of periphery and the low financing costs screamed leverage. It is no surprise there was a buildup of debt, soaring asset prices, and large current account deficits for these economies. Conversely, with persistently tight monetary policy since 2008 it is no wonder the periphery has been in a depression.

The importance of the ECB's monetary policy can be seen if we take the actual difference between the ECB policy rate and the Taylor Rule rate for each country--a measure of the stance of monetary policy--and see how it changed over the 2010-2013 period and then plot these values against the real GDP growth we get the following figure:

There is a very strong relationship here that indicates how well Eurozone economies fared over the second stage of the crisis depended on the stance of monetary policy. Even if we throw Greece out we still get a good fit:

All of this points to the Eurozone monetary crisis being the product of a poorly designed currency union. It is, in other words, far from being an optimal currency area. From this perspective, the monetary policy crisis in Europe can be thought as a structural crisis that is not going to go away anytime soon. Even a more robust monetary policy by the ECB--say a nominal GDP level target--that kept the periphery from going into a depression might still not solve the structural problem. It might solve the periphery's problems while causing overheating and buildup of imbalances in the core economies. It seems to me, then, ECB monetary policy will continue to create problems for the Eurozone moving forward.

So look forward to more Eurozone crises. Or a breakup.3

1Fernando Nechio of the San Franciso Fed, I define the core as Austria, Belgium, Finland, France, Germany, and the Netherlands while the periphery as Greece, Ireland, Italy, Spain, and Portugal.2 Like Fernando Nechio, I use the 1999 Taylor Rule. Here I use the harmonized core inflation and the IMF's output gap in the Taylor Rules.3Alternatively, the periphery economies could reform their economies to be more like the core, but that does not seem likely. Nor does it seem likely that the shock absorbers needed in the Eurozone--increased labor and capital mobility and meaningful fiscal transfers--will be ever be forthcoming. Too much history.